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Unformatted text preview: 91Chapter 9Charles P. Jones, Investments: Analysis and Management,Tenth Edition, John Wiley & SonsPrepared byG.D. Koppenhaver, Iowa State UniversityAsset Pricing ModelsCapital Allocation Across Risky and Risk Free Portfolios Fact: Bonds are riskier than Tbills and stocks are riskier than bondsCapital allocation decision between risk free and risky assets is probably the most important oneIt can account for an astonishing 94% of the differences in total returns achieved by institutionally managed pension funds John C. Bogle, Bogle on Mutal Funds, Irwin Professional Publishing 19948293Capital Asset Pricing ModelDeveloped by William Sharpe (1964), John Lintner (1965) and Jan Mossin (1966)Focus on the equilibrium relationship between the risk and expected return on risky assetsBuilds on Markowitz portfolio theoryEach investor is assumed to diversify his or her portfolio according to the Markowitz model94CAPM AssumptionsAll investors:Use the same information to generate an efficient frontier Have the same oneperiod time horizonCan borrow or lend money at the riskfree rate of returnNo transaction costs, no personal income taxes, no inflationNo single investor can affect the price of a stockCapital markets are in equilibrium 95Borrowing and Lending PossibilitiesRisk free assets Certaintobeearned expected return and a variance of return of zero (i.e. σRF=0)No correlation with risky assetsUsually proxied by a Treasury securityAmount to be received at maturity is free of default risk, known with certaintyAdding a riskfree asset extends and changes the efficient frontier96RiskBATE(R)RFLZXRiskFree LendingRiskless assets can be combined with any portfolio in the efficient set ABZ implies lendingSet of portfolios on line RF to T dominates all portfolios below it97Impact of RiskFree LendingIf wRF placed in a riskfree assetExpected portfolio returnRisk of the portfolioExpected return and risk of the portfolio with lending is a weighted average))E(Rw(RF w) E(RXRFRFp1+=XRFp)σw(σ1=98Borrowing PossibilitiesInvestor no longer restricted to own wealthInterest paid on borrowed money...
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 Spring '08
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 Capital Asset Pricing Model, security market line, rf

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